Testing a Thesis

By: Doug Noland | Fri, Sep 30, 2011
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For another unsettled week in the markets, the S&P500 slipped 0.4% (down 10.0% y-t-d), while the Dow gained 1.3% (down 5.7%). The Banks rallied 1.0% (down 32.3%), while the Broker/Dealers fell 2.0% (down 34.2%). The Morgan Stanley Cyclicals dipped 0.7% (down 26.6%), and the Transports declined 0.7 % (down 17.0%). The Morgan Stanley Consumer index increased 0.5% (down 8.9%), and the Utilities added 0.5% (up 7.0%). The S&P 400 Mid-Caps fell 1.7% (down 13.9%), and the small cap Russell 2000 declined 1.3% (down 17.8%). The Nasdaq100 dropped 3.1% (down 3.5%), and the Morgan Stanley High Tech index was hit for 1.8% (down 16.1%). The Semiconductors sank 5.9% (down 17.7%). The InteractiveWeek Internet index fell 3.8% (down 15.1%). The Biotechs dropped 3.5% (down 15.0%). With bullion sinking another $33, the HUI gold index fell 1.9% (down 8.2%).

One month Treasury bill rates ended the week at one basis point and 3-month bills closed at 1.5 basis points. Two-year government yields were about 2 bps higher at 0.24%. Five-year T-note yields ended the week up 8 bps to 0.95%. Ten-year yields rose 7 bps to 1.92%. Long bond yields added a basis point to 2.92%. Benchmark Fannie MBS yields increased 4 bps to 2.96%. The spread between 10-year Treasury yields and benchmark MBS yields narrowed 3 to 104 bps. Agency 10-yr debt spreads narrowed 5 to 8 bps. The implied yield on December 2012 eurodollar futures jumped 6 bps to 0.585%. The 10-year dollar swap spread was little changed at 19 bps. The 30-year swap spread increased about 2 to negative 22 bps. Corporate bond spreads moved wider. An index of investment grade bond risk increased 4 bps to 144 bps. An index of junk bond risk surged 108 bps to 829 bps (high since September 2009).

Investment-grade issuance this week included Caterpillar $1.0bn, 3M $1.0bn, Newfield Exploration $750 million, McDonald's $500 million, Bemis $400 million, Paccar $400 million, Private Export Funding $300 million, and LG&E Energy $250 million.

Junk bond funds saw inflows of $327 million (from Lipper). Junk issuance included Qwest $950 million, HCA $500 million, and Jeld-Wen $460 million.

I saw no convertible debt issued.

International dollar bond issuers included million Inter-American Development Bank $1.1bn, Sanofi $1.0bn, Australia & New Zealand Bank $1.3bn, XL Group $400 million and Thomson Reuters $350 million.

Greek two-year yields ended the week down 665 bps to 59.01% (up 4,678bps y-t-d). Greek 10-year yields fell 80 bps to 21.78% (up 932bps). German bund yields rose 14 bps to 1.89% (down 108bps), and U.K. 10-year gilt yields gained 6 bps this week to 2.43% (down 108bps). Italian 10-yr yields declined 9 bps to 5.53% (up 72bps), and Spain's 10-year yields fell 7 bps to 5.12% (down 32bps). Ten-year Portuguese yields sank 79 bps to 10.68% (up 410bps). Irish yields were down 113 bps to 7.46% (down 159bps). The German DAX equities index rallied 5.9% (down 20.4% y-t-d). Japanese 10-year "JGB" yields rose 4 bps to 1.03% (down 9bps). Japan's Nikkei rallied 1.6% (down 14.9%). Emerging markets were mixed. For the week, Brazil's Bovespa equities index declined 1.7% (down 24.5%), while Mexico's Bolsa gained 2.8% (down 13.1%). South Korea's Kospi index rallied 4.3% (down 13.7%). India's equities index gained 1.8% (down 19.8%). China's Shanghai Exchange fell 3.0% (down 16.0%). Brazil's benchmark dollar bond yields slipped 3 bps to 4.03%, while Mexico's benchmark bond yields jumped 24 bps to 3.63%.

Freddie Mac 30-year fixed mortgage rates were down 8 bps to 4.01% (down 34bps y-o-y). Fifteen-year fixed rates declined one basis point to 3.28% (down 53bps y-o-y). One-year ARMs added a basis point to 2.83% (down 63bps y-o-y). Bankrate's survey of jumbo mortgage borrowing costs had 30-yr fixed jumbo rates up 6 bps to 4.82% (down 49bps y-o-y).

Federal Reserve Credit dipped $1.8bn to $2.838 TN. Fed Credit was up $431bn y-t-d and $551bn from a year ago, or 24.1%. Elsewhere, Fed Foreign Holdings of Treasury, Agency Debt this past week (ended 9/28) sank a notable $32.0bn to $3.436 TN ("Developing" central banks selling dollars to accommodate "hot money" outflows?). "Custody holdings" were up $85.7bn y-t-d and $206.5bn from a year ago, or 6.4%.

Global central bank "international reserve assets" (excluding gold) - as tallied by Bloomberg - were up $1.342 TN y-o-y, or 15.6% to $9.931 TN. Over two years, reserves were $2.720 TN higher, for 48% growth.

M2 (narrow) "money" supply declined $14.1bn to $9.570 TN. "Narrow money" has expanded at a 11.4% pace y-t-d and 10.1% over the past year. For the week, Currency increased $0.8bn. Demand and Checkable Deposits slipped $1.1bn, and Savings Deposits fell $7.6bn. Small Denominated Deposits declined $3.8bn. Retail Money Funds decreased $2.4bn.

Total Money Fund assets rose $13.2bn last week to $2.634 TN. Money Fund assets were down $176bn y-t-d, with a decline of $171bn over the past year, or 6.1%.

Total Commercial Paper outstanding sank another $22.2bn (11-wk decline of $229bn) to $1.008 Trillion. CP was up $36bn y-t-d, or 4.1% annualized, although down $83bn over the past year.

Global Credit Market Watch:

September 30 - Bloomberg (Tim Catts and Ben Martin): "Corporate bond offerings worldwide plunged in the third quarter to the lowest level since Lehman Brothers'... 2008 failure as Europe's sovereign debt crisis caused investors to shun all but the safest securities. Hewlett-Packard... led borrowers issuing $543.2 billion of bonds in the past three months... Issuance fell 41% from the second quarter and 38% from a year ago as offerings by financial firms and junk-rated companies largely evaporated."

September 30 - Reuters: "Economy Minister Philipp Roesler said on Friday that Germany's parliament would not be willing to leverage the crisis fund for stricken euro zone states, after struggling to give strong support for boosting its firepower. With the ink still wet on changes to the European Financial Stability Facility (EFSF) to raise its real lending capacity to 440 billion euros and enable it to buy bonds and prop up banks, Europe's partners and financial markets are already demanding more far-reaching measures to stop the Greek crisis spreading. Some policymakers have proposed the EFSF could be used as collateral for borrowing or to guarantee a first portion of losses on sovereign debt... 'The German Bundestag (lower house of parliament) always has the last word,' Roesler told broadcaster ARD. 'I do not see any willingness there to change the upper limits or increase the liabilities through other ways such as leveraging.'"

September 28 - Bloomberg (Simone Meier and Christian Vits): "Former European Central Bank chief economist Otmar Issing, one of the architects of the euro, said Greece's exit from the 17-nation monetary union is inevitable. 'There is no other way,' Issing told Germany's Stern... according to... the magazine. With Greece's debt forecast to reach 160% of gross domestic product next year, the country needs to renege on at least 50% of its obligations and 'that can't happen within the monetary union,' Issing is quoted as saying... 'The bitter truth, unfortunately, is that the Greeks have lived beyond their means for years and will now be set back many years by their artificially inflated living standards,' Issing said."

September 28 - Bloomberg (Simone Meier): "Axel Weber, the former head of Germany's Bundesbank, said it's important to restore investor confidence in the single currency, Die Zeit reported. 'Investors have invested their money in the euro region trusting in the stability of state finances,' Weber told the Hamburg-based newspaper... 'Now they doubt that Europe still has this stability. Some are even asking themselves whether Europe still stands by the currency.'"

September 28 - UK Telegraph (Ambrose Evans-Pritchard): "Germany and America were on a collision course... over the handling of Europe's debt crisis after Berlin savaged plans to boost the EU rescue fund as a 'stupid idea' and told the White House to sort out its own mess before giving gratuitous advice to others. German finance minister Wolfgang Schauble said it would be a folly to boost the EU's bail-out machinery (EFSF) beyond its €440bn lending limit by deploying leverage to up to €2 trillion... 'I don't understand how anyone in the European Commission can have such a stupid idea. The result would be to endanger the AAA sovereign debt ratings of other member states. It makes no sense,' he said. Mr Schauble told Washington to mind its own businesss... 'It's always much easier to give advice to others than to decide for yourself. I am well prepared to give advice to the US government,' he said."

September 26 - Market News International (Chris Cermak): "European Central Bank Governing Council Member Jens Weidmann said... that using central bank's resources to boost the E440 billion firepower of of the European Financial Stability Facility was not appropriate to solve the European debt crisis. 'It's a recipe that doesn't work in Europe,' the Bundesbank president said... Asking the ECB to leverage the EFSF 'completely blurs the lines between fiscal and monetary policy,' would 'erode public confidence' in the monetary union and undermine governments' commitments to fiscal consolidation, Weidmann said. Weidmann argued solving the European debt crisis had less to do with the size of the European bailout mechanism, and more to do with European governments establishing a credible plan for fiscal consolidation. 'If you just increase the size of the rescue mechanisms, it's the best way to erode the political support' for more fiscal consolidation, Weidmann said."

September 28 - Bloomberg (Andrew Davis): "Italy sold 750 million euros ($1bn) of inflation-linked bonds at a yield more than double the previous sale of the securities. Italy sold the bonds with a real yield of 4.29%, compared with 2.07% at a February auction..."

September 28 - Bloomberg (Lorenzo Totaro): "Prime Minister Silvio Berlusconi's allies clashed over the successor to Mario Draghi as Bank of Italy governor, one month before he leaves to become president of the European Central Bank."

September 29 - Bloomberg (Emma Ross-Thomas): "Spain's postponement of an initial public offering of its lottery operator shows how Greece and other deficit-laden nations are struggling to attract equity investment as the debt crisis deepens. Spanish Finance Minister Elena Salgado said yesterday she pulled the sale of 30% of Sociedad Estatal Loterias & Apuestas del Estado SA to avoid selling it at a discount to the company's 20.8 billion euro ($28.4bn) book value. The sale was set to produce the biggest IPO in Spain's history."

September 26 - Bloomberg (Frances Schwartzkopff): "Denmark's banking crisis is deepening as the new government's plan to impose a tax on lenders threatens to deplete capital at a time when most of the country's banks have no access to funding markets. 'The banks are under severe stress,' said Jesper Rangvid, professor of finance at the Copenhagen Business School..."

September 27 - Wall Street Journal (David Enrich and Sara Schaefer Munoz): "An extraordinary dry spell in the market for long-term European bank funding is amplifying pressure on policy makers to devise a solution to the Continent's banking crisis. For the past three months, European banks have been largely unable to sell debt at affordable prices to investors... At $34 billion, the amount of senior unsecured debt issued by the Continent's financial institutions this quarter is on track to be the smallest of any quarter in more than a decade..."

September 28 - Bloomberg (Jason Kelly and Cristina Alesci): "Henry Kravis, co-founder of KKR & Co., said private-equity deals are becoming more expensive as the reluctance of banks and investors to lend drives up borrowing costs. 'As the debt markets tighten and the cost of capital goes up, something has got to give,' Kravis said... 'You just have to pay more.'"

September 27 - Bloomberg (Sapna Maheshwari and Mary Schlangenstein): "American Airlines is paying the highest interest rates since 2009 to raise cash in the debt markets... American... sold $725.7 million of 10-year bonds backed by 43 aircraft with an 8.625% coupon... In January, the... company sold similar debt at 5.25%."

September 28 - Bloomberg (Candice Zachariahs): "Australian state bonds are set for the worst quarter relative to sovereign debt since 2008 as record borrowing needs spur regional authorities to increase their share of debt sales compared with corporate offerings."

September 28 - Bloomberg (Arif Sharif): "Bond sales from the Persian Gulf region have slumped to the lowest level since 2008 as the threat of another global recession fueled the steepest surge in the region's credit risk in seven quarters."

Global Bubble Watch:

September 30 - Financial Times (Robin Wigglesworth): "The Chinese renminbi was a more popular currency for company bond sales than the euro for the first time in the third quarter, underlining the debilitating effect of the eurozone's sovereign debt crisis, while China has nurtured its own, potentially huge bond market."

September 30 - Financial Times (Tracy Alloway and Lisa Pollack): "Banks have said they expect trading activity in credit default swaps to drop in a sharp turnround in sentiment from a year ago... Some 58% of banks surveyed by Fitch Ratings expect the size of the CDS market to fall. Last year, 65% of respondents predicted trading activity would rise. The 26 banks surveyed by the agency reported a notional sold volume of $10,600bn at the end of 2010, and a notional bought volume of $11,000bn... The CDS market has been shrinking for some time, with data from the Bank for International Settlements showing the notional amount of outstanding contracts falling 8% to $29,800bn at the end of 2010 from a year earlier."

September 28 - Bloomberg (Jason Webb and John Glover): "Emerging-market companies are selling the fewest bonds in 2 1/2 years as investors drive borrowing costs higher amid a global economic slowdown. Borrowers in developing nations issued $16 billion of fixed-income securities since the end of June, a 72% decrease from $58 billion in the previous quarter... Prices of emerging-market corporate notes are down 4.7%, the biggest drop since the 20% rout after Lehman... collapsed..."

September 28 - Bloomberg (Drew Benson and Cristiane Lucchesi): "Brazil's corporate dollar bond sale drought is reaching its longest in 2 1/2 years as the threat of a banking crisis in Europe drives up borrowing costs. There have been no dollar-denominated debt offerings from Brazilian companies in overseas markets since July 20... The average yield on the country's corporate bonds jumped 89 bps... since the end of July..."

September 27 - Bloomberg (Anurag Joshi): "International bond sales by India's companies have slumped to the lowest in more than a year as their borrowing costs surge to levels not seen since the collapse of Lehman..."

September 28 - Bloomberg (Camila Russo): "Argentina's central bank paid the highest yields in almost two years on fixed-rate peso bonds sold at its weekly auction as investors switch their deposits to dollars and capital flight increases. Yields for fixed-rate bonds of the shortest maturity, due in 126 days, rose 26 bps from last week's sale of 112-day bonds to 13.4%..."

Currency Watch:

September 29 - Bloomberg (Ben Bain and Nacha Cattan): "Mexico's peso is posting its worst quarter in three years on concern Europe's financial crisis will exacerbate a slowdown in the U.S. economy, the destination for 80% of the Latin American country's exports. The peso's 13.6 percent tumble against the dollar from the end of June through yesterday is the biggest since the three- month period ended December 2008... The currency's plunge handed investors in peso bonds a loss of 8.3 percent in dollar terms this quarter..."

The U.S. dollar index added 0.4% this week to 78.80 (down 0.3% y-t-d). For the week on the upside, the Swedish krona increased 0.9%, the British pound 0.9%, and the South African rand 0.3%. On the downside, the Mexican peso declined 2.4%, the Brazilian real 2.4%, the Canadian dollar 2.1%, the New Zealand dollar 2.0%, the Australian dollar 2.0%, the South Korean won 0.9%, the euro 0.8%, the Danish krone 0.8%, the Singapore dollar 0.7%, the Japanese yen 0.6%, the Norwegian krone 0.3%, the Swiss franc 0.3% and the Taiwanese dollar 0.3%.

For the quarter on the upside, the Japanese yen increased 4.5%. On the downside, the Brazilian real declined 16.8%, the South African rand 16.4%, the Mexican peso 15.7%, the Australian dollar 9.9%, the South African rand 9.4%, the Canadian dollar 8.3%, the New Zealand dollar 8.2%, the Norwegian krone 8.2%, the Swedish krona 7.9%, the euro 7.7%, the Danish krone 7.5%, the Swiss franc 7.5%, Singapore dollar 6.0%, the Taiwanese dollar 5.8% and the British pound 2.9%.

Commodities and Food Watch:

The CRB index declined 1.2% this week (down 10.4% y-t-d). The Goldman Sachs Commodities Index fell 1.4% (down 6.5%). Spot Gold declined 2.0% to $1,624 (up 14.3%). Silver was little changed at $30.08 (down 3%). November Crude slipped 65 cents to $79.20 (down 13%). November Gasoline rallied 0.5% (up 4%), while November Natural Gas dropped 2.7% (down 17%). December Copper slid another 3.9% (down 29%). December Wheat fell 4.9% (down 23%), and December Corn sank 7.2% (down 6%).

China Bubble Watch:

September 28 - Bloomberg: "The cost of protecting China's sovereign debt from default jumped to the highest level since March 2009... Credit-default swap contracts on China surged 16 bps to 170, according to CMA... 'Everyone is getting more concerned about risks accumulating domestically,' said Ju Wang, a fixed-income strategist at Barclays Capital... 'Eventually in China, the burden in the banking sector will have to be reflected in the sovereign balance sheet.'"

September 28 - Bloomberg (Kyoungwha Kim): "China's clampdown on property loans and concern that local authorities will struggle to pay their debts are driving up corporate borrowing costs by the most in four years relative to government bonds. The difference between yields on 10-year notes issued by top-rated companies and government securities widened 46 bps this quarter to 221 bps."

September 27 - Bloomberg: "China's property company bonds are delivering the biggest losses in the world among developers this quarter amid speculation the banking regulator may close another avenue of funding. Dollar-denominated debt of Evergrande Real Estate Group Ltd., Hopson Development Holdings Ltd. and other Chinese homebuilders rated below investment grade has plunged 19.9 percent since June 30..."

September 27 - Bloomberg: "Chinese developers face an 'increasingly severe' credit outlook, which may force them to cut prices and turn to costlier funding sources as sales weaken, Standard & Poor's said. A 30% decline in sales may leave many developers facing a liquidity squeeze, S&P said... Most developers would be able to 'absorb' a 10% sales drop next year, the credit rating company said. 'The worst isn't over for China's real estate developers,' S&P analysts led by Frank Lu wrote... 'Developers are bracing themselves for slower sales and lower property prices ahead.'"

India Watch:

September 29 - Bloomberg (Kartik Goyal and Tushar Dhara): "India's federal government increased its debt-sale target for the second half of the financial year by about 32%, citing a drop in state-run small savings plans. Ten-year bonds slumped. The finance ministry plans to raise 2.2 trillion rupees ($45 billion) selling bonds in the six months ending March 31..."

Asia Watch:

September 28 - Bloomberg (Novrida Manurung): "Indonesia has 'informally' asked mutual funds, insurance companies and pension funds not to sell shares in the market, Nurhaida, chairman of the nation's capital market regulator, said..."

September 29 - Bloomberg (Tushar Dhara): "India's food inflation accelerated for the first time in four weeks, maintaining pressure on the central bank to raise borrowing costs to tame price gains. An index measuring wholesale prices... gained 9.13%... from a year earlier..."

Latin America Watch:

September 26 - Bloomberg (Alexander Ragir): "Brazil's central bank will miss its inflation target this year for the first time since 2003, a central bank survey of economists shows. Consumer prices will rise 6.52% this year..."

September 29 - Bloomberg (Camila Russo): "Argentina's central bank is selling dollars at the fastest pace in almost three years to meet increased demand for foreign currency, depleting the amount of reserves it can use to pay debt as capital flight picks up. Policy makers sold $1.98 billion of reserves from July 1 through Sept. 16 to prop up the peso... Average government dollar bond yields jumped 265 bps since the end of June to 11.95% on Sept. 26..."

Unbalanced Global Economy Watch:

September 28 - Bloomberg (Jana Randow and Christian Vits): "Inflation in Germany... accelerated more than economists forecast in September to the fastest pace in three years. The inflation rate... increased to 2.8% from 2.5% in August..."

U.S. Bubble Economy Watch:

September 30 - Dow Jones: "The income of Americans fell for the first time in nearly two years during August, a bleak sign for an economy that relies on consumers' willingness to spend. ...personal income fell 0.1% last month, after meager gains in prior months."

September 26 - Bloomberg (Steve Matthews and Timothy R. Homan): "St. Louis Federal Reserve President James Bullard said the long-term path of U.S. growth may be lower after the collapse of housing prices because investment in residential structures won't return quickly to 2006 levels. 'It is not reasonable to expect the economy to climb rapidly back to the 2007, Q4 peak since part of that peak was due to artificial growth driven by bubble behavior,' Bullard... said..."

September 27 - New York Times (Reed Abelson): "The cost of health insurance for many Americans this year climbed more sharply than in previous years, outstripping any growth in workers' wages and adding more uncertainty about the pace of rising medical costs. A new study by the Kaiser Family Foundation, a nonprofit research group..., shows that the average annual premium for family coverage through an employer reached $15,073 in 2011, an increase of 9% over the previous year... Many businesses cite the high cost of coverage as a factor in their decision not to hire, and health insurance has become increasingly unaffordable for more Americans. Over all, the cost of family coverage has about doubled since 2001..."

September 27 - Bloomberg (Pat Wechsler): "More people in the U.S. ignored their doctor's advice and skipped prescription drugs or medical procedures to save money in 2011 than a year earlier, a Consumer Reports survey showed. Almost half of the 1,226 consumers taking at least one medication said they didn't fill prescriptions, took less medicine than a prescribed dose or failed to undergo a medical test advised by their physician... That's 9 percentage points higher than the 39% reported in 2010 by the annual survey."

Central Bank Watch:

September 29 - Bloomberg (Joshua Zumbrun): "Federal Reserve Bank of Philadelphia President Charles Plosser said the central bank may be undermining its own credibility by pushing forward with monetary easing that will do little to boost growth. 'The actions taken in August and September tend to undermine the Fed's credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery,' Plosser said... 'It is my assessment that they will not.'"

Muni Watch:

September 27 - Bloomberg (William Selway): "For U.S. cities, the effects of the real-estate collapse and the recession it helped spark in 2007 are showing few signs of ending. More than half, 57%, of municipal officials said finances were worse in fiscal 2011 than in 2010, the National League of Cities said... Inflation-adjusted revenue is headed for a fifth- straight annual drop, while worker health-care and pension costs rose for more than 80%."

September 28 - Bloomberg (Michelle Kaske and Andrea Riquier): "This was supposed to be the worst year ever for U.S. states and municipalities. Instead, they are obtaining money at the lowest interest rates in more than two years after predictions of rising defaults failed to materialize."

September 27 - Bloomberg (William Selway): "U.S. state and local-government tax revenue rose 6.9% in the second quarter from a year earlier... Tax collections rose to $344.5 billion from $322.3 billion in the same quarter a year earlier, the Census Bureau reported. Property-tax collections, a main source of revenue for local governments, dropped 1.2%."


Testing a Thesis

"The Alchemy of Finance" is one of the greatest financial books ever written. In this 1988 classic, George Soros developed his thesis of how finance and the markets operate and then tested his analytical framework in real life market circumstances. I have drawn heavily from Mr. Soros' body of work in developing my Global Macro Credit and Markets Analytical Framework. And in the spirit of "The Alchemy," it is imperative to constantly challenge and test my thesis in the real world and be willing to adapt to ensure the framework is capturing real world dynamics. It is absolutely fundamental for theoretical concepts and analytical frameworks to be reality-based.

My thesis in a snapshot: A unique period of unfettered global Credit has spawned myriad historic Bubble Dynamics. The unprecedented policy response, fiscal and monetary, at home and abroad, to the bursting of the 2008 mortgage/Wall Street finance Bubble unleashed the "Global Government Finance Bubble." This Bubble was fueled by unprecedented growth in global sovereign borrowings and the unprecedented expansion of global central bank balance sheets, along with associated market pricing and risk-taking distortions. Importantly, this "global reflation" stoked already overheated "Developing" country Credit systems and economies to the point of dangerous Bubble fragilities. This view is supported by extraordinary Credit expansion throughout China, Brazil, India and "Developing" economies more generally. I have argued that post-2008 stimulus pushed China into a dangerous "terminal phase" of Credit Bubble excesses.

I have drawn parallels between last year's Greek crisis and the eruption of subprime in 2007. Both were the initial cracks ("marginal borrowers" denied access to inexpensive market-based finance) in respective historic Bubbles (2007: U.S. mortgage/Wall Street finance; 2010: Global sovereign debt). With Greek crisis contagion having this summer spread to the third-largest issuer of sovereign debt in the world (Italy) and having severely impaired the European banking system, I have seen ample confirmation of this facet of my thesis.

From my vantage point, last week appeared to provide another critical global crisis inflection point. In particular, escalating market tumult and contagion effects afflicted the "Developing" currencies and bond markets. To that point, they'd been fairly resilient. Yet global de-risking/de-leveraging dynamics seemed to lurch forward - and ever closer to the point of turning uncontrollable. I'll suggest that the coming weeks will be crucial. The consensus view holds that the "Developing" economies and Credit systems are robust and, as such, will prove resilient in the face of "developed" world structural financial and economic woes. I fear that the "Developing" systems have themselves become acutely vulnerable to the downside of Bubble Dynamics.

The soundness of "Developing" Credit systems has quickly become a critical issue. Conventional analysis doesn't foresee major problems. The popular bullish thesis is premised on powerful secular growth dynamics. From my analytical perspective, there is acute global systemic vulnerability to the reversal of what were massive financial flows (Trillions?) to the "Developing" world. And it may be nebulous, but there is the issue of possibly enormous "carry trade" inflows that previously emanated from the leveraged speculating community (sell low-yielding dollar securities and take proceeds to leverage in higher-returning global risk assets). The "Developing" world also enjoyed huge investment fund flows and foreign-based capital investment. The global banking community, especially the European financial goliaths, also made a major push to capitalize on robust "Developing" lending, fund flow, M&A, and asset inflation backdrops.

I was this week recalling the 2001/2002 post-tech Bubble monetary "debate." Back then, the intellectual deflation hysteria fixated on the need to reflate the "general price level." With the year-over-year change in the Consumer Price Index (CPI) in steady decline for much of 2001 and touching a low of 1.0% in 2002, there was a big push to have the Fed orchestrate sufficient monetary ease to inflate the CPI out of the deflationary danger zone.

I argued at the time that there was in reality no general level of consumer prices for the Fed to actively manipulate. Instead, there were myriad complex supply and demand pricing dynamics throughout the U.S. and global economy, as well as mercurial asset and financial market trading dynamics. Indeed, the most direct impact of Fed policy interventions (as had been repeatedly demonstrated by 2001) was in the asset and securities markets. In particular, by 2001/02 it was readily apparent that a powerful Inflationary Bias had taken root both in sophisticated leveraged speculation and throughout the U.S. housing sector. The Fed's push to reflate CPI unleashed powerful Bubble Dynamics throughout mortgage finance, the hedge funds/Wall Street proprietary trading desks/derivatives/"structured finance," and U.S. (and global) housing markets.

At the time, the most vocal proponents of ultra-loose money, including top officials at the Fed, were more than content to risk some excess in housing to ensure a successful recovery and victory over "deflation." The economy was stagnant, the corporate debt market was in tatters, technology stocks had collapsed and equities were generally out of favor. So the robust government-sponsored enterprises (GSEs), the (government-backed) agency and mortgage-backed securities (MBS) marketplace, the opportunistic hedge funds, and the resilient housing sector were viewed as the powerful locomotive candidates necessary for system Credit reflation.

It's certainly no coincidence that, at the epicenter of the 2008 financial crisis, these Credit "expedients" came back to haunt the system. Importantly, the most robust reflationary "Monetary Processes" (i.e. GSE risk intermediation, Wall Street "structured finance," hedge fund leveraging and the inundation of finance upon U.S. housing markets) and "Inflationary Biases" (i.e. home and security prices, consumption, and consumption-based investment) were exploited and pushed to dangerous Bubble extremes. At the end of the day, policy was successful in moderately reflating the so-called "general price level" but at an immoderate cost to financial and economic system stability.

The 2008 crisis became a full-fledged global private-debt and economic crisis. Calls to aggressively battle the "scourge of deflation" became only more impassioned (if you disagreed, you were clearly a moron). Interestingly, analytical focus moved well beyond the "general price level." With the Fed admitting that its traditional monetary mechanism was now broken ("pushing on a string"), the Bernanke Fed moved decisively toward targeting asset prices - especially bond yields and our stock market. Zero rates and the massive expansion of the Fed's balance sheet could at the same time ensure marketplace liquidity, incentivize speculation in risk assets, and further devalue our beleaguered currency. A massive expansion of federal debt and a weaker dollar would bolster U.S. business performance and spur a domestic economic rebound. And it certainly didn't hurt that loose money would also work to sustain Developing" world growth dynamics - locomotives to help pull the world economy out of the post-2008 doldrums.

Replaying the acquiescence to U.S. mortgage excesses, I believe global policymakers in the post-2008 panic were willing to look the other way to massive "developed" sovereign debt issuance and enormous excesses and distortions in both the world's financial apparatus and "Developing" Credit and economic systems. Massive deficits in Europe's periphery (as well as in the U.S.); a miraculous resurgence in leveraged speculation, "carry trade" flows and derivative trading; and extreme global imbalances were simply (in 2003-2007 fashion) disregarded. These were, after all, this reflationary cycle's most robust "Monetary Processes" and "Inflationary Biases"; this cycle's reflation "expedients" and growth locomotives.

It is this analytical backdrop that makes me fearful that the global crisis has commenced another escalation phase. Heightened uncertainty has moved well beyond Greece, "the periphery" and the greater euro zone. There are now major questions - and worries - with respect to even the Chinese and "developing" Asian booms. It is worth noting that Chinese Credit default swap (CDS) prices surged 38 bps this week to 197 bps, up about 110 bps from the July low to the highest level since early-2009. CDS prices have spiked through the "Developing" markets - Eastern Europe, Asia and Latin America.

And so we'll be watching attentively. Thus far, there is mounting support for the systemic fragility thesis with respect to the entire "Developing" world. And despite the positive outcomes in voting for expanding the scope of the European Financial Stability Facility (EFSF), one had to squint this week to see improvement in Europe's desperate financial situation. Meanwhile, there was evidence of ongoing pressure on global "carry trades" and the leveraged community more generally. Keep in mind that the gigantic (hedge and mutual) fund operators became only more monstrous over the past few years. It will not be easy for the dominant players, especially in the face of faltering marketplace liquidity and diminished "hedging" markets, to get their trading books repositioned for today's new realities.

And I'd be remiss if I failed to note that chairman Bernanke was compelled to dangle the QE3 carrot a bit this week. The initial, yet fleeting, response was a little market-comforting relief from recent dollar strength. I assume that QE3 will be forthcoming, although when it eventually arrives it will likely be met with disquieting internal Fed dissent, political risk, public angst and, perhaps, a lot of market indifference. With each passing day of global de-risking/de-leveraging fallout, the market better appreciates that quantitative easing is suffering from a diminished capacity to sustain global Bubble dynamics. The reality is that the scope of QE3 would have to be enormous to reverse the unfolding global bursting-Bubble backdrop. This will create a serious dilemma for the Fed come decision time (a QE2-sized QE3 risks disappointing the markets, while a Trillion handle might just push shock and awe to the breaking point). It surely sounds silly these days even to mention it, but let's also not completely disregard the festering issue of a policy-induced Treasury market Bubble matched against he recent 3.8% y-o-y increase in consumer prices.

Thus far, I've noticed little interest in assessing the early effects of Dr. Bernanke's experimental manipulation of bond yields, stock prices and dollar devaluation. I'll throw in my two cents worth: the Fed has orchestrated an absolute mess with respect to global Credit, financial markets and economic uncertainties - the type of extreme uncertainty that is keenly hostile to risk-taking and financial/speculative leveraging.

I know. It all appeared to function relatively (and seductively) well, that is so long as global reflationary dynamics - massive sovereign debt issuance, speculator re-leveraging, global banking system re-risking, buoyant global "hedging" and derivatives markets, and spectacular "Developing" world Bubble inflation - were all in play. Well, I am increasingly convinced that these various dynamics are in the process of falling like dominoes. This thesis will be tested. For now, my analytical framework has me confidently fearing that the deleterious consequences from this cycle's reflationary excesses will prove especially formidable - and increasingly immune to policy prescriptions. This is what global equity (and CDS and risk asset) prices are shouting rather loudly and clearly, although our market continues listening for that little repetitive whispering voice: "next year is an election year and there's way too much at stake for Washington to allow a debacle."

 


 

Doug Noland

Author: Doug Noland

Doug Noland
The Credit Bubble Bulletin
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Source: The Contrarian Take http://blogs.forbes.com/michaelpollaro/
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